Board Independence is Less Effective at Deterring Accounting Fraud in Family Controlled than in Publicly Held Corporations

An Annotated Bibliography by Todd Benschneider

Prencipe, Annalisa. Bar-Yosef, Sasson. “Corporate Governance and Earnings Management in

Family-Controlled Companies.” Journal of Accounting, Auditing and Finance. April 2011,

Vol. 26 Issue 2, p199-227. 29p. Database: Business Source Alumni Edition.

Annalisa Prencipe, PhD. and senior lecturer at SDA Bocconi School of Management with her team of researchers conducted a study of 249 firms to compare the quality (long-term sustainability) of profits in family controlled firms to earnings of publicly held companies. The study investigated the impact of “earnings management strategies” a term that The Journal of Accountancy defines as “the discretionary distortion of revenue, expense and depreciation schedules to optimize short term goals such as executive bonuses, budget targets or manipulation of stock prices.”  The results of the study were intended to provide accounting firms with new tools for identifying ratios and patterns that detect shareholder fraud in family controlled firms.

In publicly held firms strong incentives such as performance bonuses, performance reviews and salary bonuses lure executives to portray company financials in the most positive light, while concealing negative information from financial reports. However, over reporting earnings provides inaccurate feedback to the product development, finance and marketing departments who rely on accurate reporting to steer future products and operations strategy. Extended periods of inaccurate market feedback can undermine the long term economic health of the company. Stockholders can reduce mismanagement by electing an independent board of directors who hire, evaluate, supervise and fire top level executives to ensure that strategic decisions represent the shareholders’ best interest.

Prencipe explains that “A typical board structure is composed of outside directors and top company officers. Outside directors are appointed by the company’s shareholders and are assumed to be acting in the shareholders’ interests. However, the inclusion of top management among board members may give rise to a conflict of interest as management may attempt to transfer wealth from stockholders by taking advantage of information asymmetry. The results show that the increase in shareholder wealth is significantly higher when the board is dominated by independent directors.”

Recent trends in corporate governance now encourage firms’ directors to enforce accurate financial reporting. Board oversight can identify executives who exploit short range strategies that inflate profits to capitalize on performance bonuses. By the time the earnings management schemes unravel, the executives involved have often retired or moved on to other companies, which limits the legal recourse available to the stakeholders. Public demand in response to recently publicized investor fraud cases have prompted legislators to issue regulations that hold board members accountable to shareholders for fraudulent reporting of the executives they oversee. Regulatory changes in corporate governance have been eliminating the participation of company executives from the board of directors to reduce their influence over the boards’ objectivity, especially by eliminating CEO’s from also serving as the Chairman of the Board.

However, family controlled companies face different incentives to publish inaccurate financials, and further compounding the distribution of power, the CEO is often times also the largest stockholder of the company, entitling them to serve as the Chairman of the Board.  Prencipe wrote “Current literature suggests that, although founding family ownership seems to be associated, on average, with higher earnings quality, the extent of earnings management remains an open issue for family controlled firms. Since most families with controlling interest in their company possess a long term vision for growth and therefore make decisions that favor long range goals rather than boosting quarterly profits.”

Prencipe believes that while experts agree that there is less incentive for family controlled firms to over report earnings, that instead those companies manage earnings to secure the family’s controlling interests, minimizing the distribution of wealth to minority shareholders. She hypothesized that recent corporate governance restructuring would be less effective in family controlled companies whose self-interest lies in underreporting earnings, especially present in where the family also served in salaried executive positions by increasing family members bonuses or siphoning private benefits at the expense of other shareholders such as supplier kickbacks, travel expenses and other concealable business write offs.

The study was expected to validate previous research that had shown a lower incidence of earnings management under a board of directors with independent decision making authority, especially those boards lacking a CEO chair holder.  A board possessing low levels of independence has many of the company executives voting on board decisions, with the CEO also serving as the chairman of the board. In cases of a highly independent board the CEO does not hold a seat and possesses only subordinate levels of authority in regulating corporate accounting. However this study would specifically compare results from widely held public corporations against those from private firms and measure the estimated earnings management strategies present in the financial reports. Levels of earnings management in the companies would be calculated from a fraudulent accounting indicator: abnormal working capital accruals (AWCA).

Prencipe and Bar-Yosef conducted a study of Italian corporations by applying AWAC audit calculations to a sample of 249 Italian corporations consisting of four publicly traded corporate governance structures:

1-      Family Controlled with CEO on the Board of Directors

2-      Family Controlled with no executives on the Board of Directors

3-      Publicly Held with CEO on the Board of Directors

4-      Publicly Held with no executives on the Board of Directors

The intent of their study was to see if a correlation could be found that suggested that any of these four governance structures yielded a higher quality long range financial growth. The results validated several previous studies that found higher quality earnings generated by publicly held corporations with a highly independent board of directors. The results also supported Prencipe’s hypothesis that family controlled firms outperformed publicly held firms in earnings quality; however there was a less pronounced advantage to private firms with a highly independent board when compared to public firms with an identical governance structure.

Prencipe’s closed her article with:

“Our conclusions may lead regulators and academics to reevaluate the effectiveness of some corporate governance models when applied to family controlled companies. In particular, our results suggest that regulators should pay special attention to the selection of board members. For the benefit of all shareholders, it is important to guarantee substantial independence of the board. Our results are also useful to users of financial statements, suggesting that a company’s ownership structure and its corporate governance characteristics should be taken into account when accounting numbers are used.”


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